Wednesday, October 13, 2010

What Happens When Cities Go Broke?

In a new article on Forbes.com, author Jonas Elmerraji examines the possibility of a city or municipalities filing for bankruptcy. It may seem strange, but just two years ago Vallejo, CA filed for bankruptcy. With the economy stalling, we may just see more cities looking toward bankruptcy to restructure debts and obtain more attractive financing.

In today's shaky economic environment, bankruptcy has become a dreaded--yet not all that uncommon--phenomenon. But what happens when it's not a person or company going broke, but an entire city? With added emphasis on government finances in 2010, it's a question that more and more citizens are beginning to ask themselves.

Municipal and state bonds are investments that touch a huge percentage of the investing public. And as we're seeing right now in Europe, there's no limit to the size to which government budget problems can grow.

Here's a look at what it means for a city--or a county or state--to go bankrupt, including the fallout for its citizens and stakeholders.

New Kid on the Block

Bankrupt cities are a relatively new phenomenon. Until the 1930s, it was legally impossible for U.S. cities to declare bankruptcy due to the absence of any municipal bankruptcy legislation. That changed in 1934 when the Bankruptcy Act was modified to include municipalities, a change made in response to the growing number of insolvent towns in the U.S. during the Great Depression.

After a number of evolutions and changes, the rule emerged as today's Chapter 9 of the U.S. Bankruptcy Code. Chapter 9 bankruptcies are available exclusively to municipalities. But there are some significant differences between a city's Chapter 9 bankruptcy and the much more common personal and business bankruptcies that take place on a daily basis.

Chapter 9 bankruptcies aren't designed to extinguish excessive debts. Instead, their purpose is to aid in reorganization by allowing a city to break untenable contracts and obtain more attractive financing. That's a good thing for a city's bond holders, who would typically see their assets at risk in a corporate bankruptcy.